Why don't (Indian) MSMEs get risk capital?

(Last revised 4-Mar-2010, Send comments to galatime@gmail.com)

There are a variety of reasons why innovative Micro, Small and Medium Enterprises (MSMEs) in India find it virtually impossible to raise risk capital. Seed capital in the 20 lakh - 2 crore range is rarely available; only the largest SMEs looking for tens of crores stand a chance.

Here are 10 important ones:

1. Asymmetric information

This is econ-speak for "I know more - and can hide way more - about my company than you (the investor) can imagine". This is similar to the used car (lemon) problem. Since the seller has much more
information than the buyer, the outcome is either a no-sale or a deeply discounted buy offer.

2. Risk aversion

This is much more relevant to India where many HNIs are highly risk-averse. Think of rich professionals/doctors/lawyers/etc. who could potentially be angel investors. After a lifetime of investing in fixed deposits, gold, real estate & mutual funds, imagine risk-funding MSMEs. A common attitude is - "I am ok if I don't make a big RoI, but I want at least my principal back". In a decade where stock markets have done well and real estate has done very well, the opportunity cost of capital is high.

3. Collateral (not !)

Innovative MSMEs don't have enough business assets (land, equipment) as collateral against which to raise capital from banks/investors. Providing personal guarantees for business capital is asking the entrepreneur to take on double the risk. Not only does he have to create a new venture, but also incur personal liabilities.

4. Involvement vs. Interference

Angel investors / HNIs in India are likely to be perceived as meddling/interfering by MSMEs. Board seats, stringent deal terms, etc. may be seen as obstacles to running a business. Entrepreneurs crave freedom to operate, while investors need visibility into the companies they've funded.

5. Dilution

In India, many entrepreneurs tend towards family businesses and empire-building. For them to share a double-digit stake in the company and open the kimono to venture investors is a bitter pill to swallow.

6. Investor incentives

There are no incentives for angel investors in India. No tax breaks, deductions, loss write-offs, matching funds (leverage), nothing. In case of abuse of funds, investors are unlikely to get fast legal judgments and enforcement. If anything, the government has recently made things worse.

Many MSMEs may have a profitable (but small) business and need risk capital for rapid growth & diversification. However, offering a stake to the investor in the existing venture - which they've likely built on their own - doesn't come easy. The investor, on the other hand, looks upon that stake as insurance.

9. Investment costs

There is a certain minimum due diligence that a venture investor needs to do before funding a startup. Given that 1 out of 100 MSMEs may get risk capital, the costs of serving them are too high - whether for VCs or banks. It is more rational to aim for the 'bigger bang for the buck' investment deals.

10. Exit options

Since it is rare than an MSME will go public via an IPO, investors have to bet on M&A exits, which are also not common for companies with revenue in tens of crores or less. That puts the investor in a bind - how does he exit and realize cap gains? There is no market for trading of private equity stakes in India. The most likely option is a buy-out by the entrepreneur/promoter. This exit scenario keeps most risk investors away from MSMEs.

Of course, these issues are more or less well-known, and agencies such as SIDBI are trying to address them. But I believe there is a more comprehensive approach to this; and that it can a viable, profitable venture in itself.